Tuesday, March 20, 2007

Psychology of a Housing Bubble

Question: How can a tulip bulb become worth $76,000?

Answer: When a buyer is willing to pay that much.

The price of an asset in a competitive market, economists tell us, occurs at the equilibrium level where the supply curve intersects the demand curve on a graph where price level lies on the y axis and quantity demanded lies on the x axis.This pricing theory, so elegant and simple, is the foundation of every course in economics, and is accepted as a universal economic truth that concisely explains consumer behavior in all corners of the free market.It is said that this model can be used to explain and predict changes in the price and quantity of goods sold, but unfortunately the usefulness of this model is limited by our ability to accurately ascertain the necessary inputs.The model has failed miserably in the past because we have no accurate method of drawing the supply and demand lines on the graph with any degree of scientific accuracy.Mathematical modeling does not determine where the demand (and supply) lines are to be drawn. Consumer (and supplier) behavior determine location and slope of any line, and unfortunately for economists, human behavior is not influenced by graphs, equilibrium models, and demand theories.

Tulips

At the peak of the market In Holland in the1630’s, tulib bulbs sold for as much as $76,000 (present day dollars).Six weeks later the same bulbs traded for less than a dollar.Economic modeling cannot predict or explain such pricing phenomenon because economic models make a critical assumption about human behavior that is rarely an observable truth.Economists assume rational consumer behavior in order to make future predictions.History has proven that nothing could be less rational than making such an assumption.

To explain buyer behavior in any market where prices are changing requires careful consideration of the psychology of the market.Irrational and manic behavior influences every market, and the result is that prices change for reasons that cannot be explained without considering the ever-changing beliefs of the market’s participants.The story of Tulips in Holland is merely one example of how market psychology can change without any fundamental changes in the underlying market, and cause ruthless damage to those too deeply entrenched in the mania.

The story began in 1593, when Conrad Guestner imported the first tulip bulb into Holland.Initially the rare bulbs were purchased by the wealthy as a sign of status and wealth, but soon thereafter speculators entered the market seeking to turn a profit, and as demand increased along side with trading activity, speculators earned very healthy profits.Tulips began to be traded on market exchanges, and by 1634 trading was conducted mainly by people in the middle class looking to make their fortunes in a market where prices steadily rose.Soon the entire Dutch nation, hypnotized by the success of the market, were selling their farms, livestock, and life savings to speculate on a single tulip bulb, and prices rose astonishingly quickly, with few people pausing to consider the rationality of the market’s behavior.Trading activity quickly spread across Europe to other exchanges, where tulip derivatives (in this case option contracts and futures contracts) allowed even greater speculation by broader cross sections of the population.

Then came a seemingly insignificant event.The Dutch government began issuing warnings and started to develop regulation to help control what they believed was dangerous price appreciation.This prompted some speculators to cash out, believing that prices tomorrow could be lower than they are today should such regulation be imposed.Furthermore, another curious event happened.People grew new tulip bulbs, and tulips weren’t quite as rare any more.Soon thereafter, tulips began a slight downtrend, and all the speculators began to panic at the same time – unfortunately panic spreads like a virus, just much more quickly.With remarkable synchronism, the speculators’ had the identical reaction to lower future price expectations – sell the tulip bulbs today.The resulting price crash, possibly predictable by a psychologist or behavioral expert, could not have been predicted by an economic algorithm.The Dutch government tried to engineer a bailout, but the problem was too massive to prevent large numbers of bankruptcies, defaults, and lost fortunes.Bulbs were worthless, and the Dutch economy was crippled for decades.

Feedback Loops

What caused the rapid crash of tulip prices has become known as a “feedback loop”, where investors react to price declines resulting from a minor sell-off by selling themselves, leading to greater price declines, and further selling by other investors.Robert Schiller, in “Irrational Exuberance” relied on this theory of investor psychology to accurately predict the stock market crash in 2000[1].Schiller analyzed the 1987 stock market crash and, where he concluded that feedback loops precipitated that crash, a conclusion supported by his own research and by the Brady Commission study conducted in the wake of the crash.

It is important to recognize that “feedback loops” is a psychological theory unrelated to pricing fundamentals, such as earnings or interest rates.Psychological theories about asset class price declines are considered by about 2/3 of all institutional and individual investors as being more important in predicting price declines than fundamental pricing methodologies[2].This belief of most investors has far reaching consequences, as any student of Game Theory will soon recognize.At the heart of Game Theory is the concept that investors make their own investment decisions based on their expectations of what decisions other investors will make.If 2/3 of investors believe that psychological phenomena play the most important role in the pricing decisions of other investors, then the importance of any clues relating to the psychology of the market become immediately apparent.The research suggests that the most successful investors may be those who are the best psycho-analysts for the market, more than they are experts in predicting the future fundamental performance of a market’s underlying assets.

Predicting Market Psychology Today

The tulip mania, the 1987 stock market crash, and the 2000 dotcom bust are merely illustrative of how consumer psychology can lead to irrational behavior and unsustainable and unpredictable changes in price levels.When consumers believe that an asset class will appreciate, be it tulips, tech stocks, commodities or real estate, irrational behavior can lead to irrational prices.The ability to identify irrational behavior early is essential to prosperity in any investment market, as irrational prices always correct themselves at some point.

The key to identifying irrational behavior is to identify euphoric public sentiment about an asset class, accompanied by manic speculative investment activity, and rapidly rising prices.When these three market characteristics align, this is normally a sign that what will follow is decreased expectations regarding the future value of the asset class as some speculators begin to sell of and capture profits, while others introduce new supply.These events trigger the belief that asset prices will be lower tomorrow than they are today, and such thinking explodes across the investment community, and prices correct, or “mean revert”.

Today, we see some evidence of manic public sentiment about real estate.Some notable proof of this sentiment can be found in:

The proliferation of seminars prosthelitizing the benefits of investing in real estate.One of the most notable of these seminars is hosted by the icon of many wannabe millionaires, Donald Trump.[3]

A reality TV show titled “Flip This House” where an investor buys a house, remodels it and tries to sell it for a profit.[4]Their website even include a section titled “Flip Tips” where they give the viewer tips so they can go play the game on their own.[5]

Amazon.com currently has 1694 books listed in its real estate investing section[6] This notable publication is the 6th most popular:

Realtor.com, a site dedicated to helping people find real estate, real estate agents and mortgages is one of the top 60 sites in the United States, beating out Travelocity.com, Orbitz.com, Lycos.com, Excite.com, WalMart.com, Reuters.com, WallStreetJournal.com and of course, IRS.gov.[7]

The problem of course is that market psychology is not as easy to predict as I have just described.The best we can do is compare the psychology of the current market to other periods in history where time has proven that consumer behavior was irrational.It may be helpful to read the above history of the Tulip craze one more time, this time comparing the story to today’s real estate investment environment.Today’s real estate investors may be well advised to do the same for other periods of investment irrationality and compare the characteristics of those markets to those of the real estate market today.If the analogies strike the investor as somewhat scary, then this could be a valuable insight into the market that might help him capture any gains he has achieved before losing them.If the investor still believes concern is unwarranted for the time being, then this could confirm his bullish view and allow him to move forward with greater confidence and certainty about his position.

Triggers of Shifting Market Sentiment

If one can accurately predict a forthcoming shift in investor sentiment related to an asset class, then profit potential is unlimited.Unfortunately predicting such a shift with accuracy is impossible.However, investors do have some clues that can be used to shift the odds his favor.Human behaviour experts submit that the brain merely responds and reacts to inputs received from the body’s sensory organs.On a micro level, we cannot expect to understand any individual investor’s mechanisms for processing inputs and formulating appropriate responses, but on a macro level we can look to the inputs that are available to the market, and make assumptions about what reactions we can expect based on those inputs.To go one step further, we can try to evaluate which are the inputs that the most number of investors are exposed to, which may help us predict the responses of large groups of investors, and hence broad market moves.

Fortunately the many of the inputs available to investors are not proprietary.Most investors rely heavily on news reports, investing journals, publicly released market data, government reports, and expert analysis, all of which is available to anyone willing to look.This mode of analysis is by no means new – one of the most popular methods by which historical market moves have been analyzed is by reference to the media accounts and published reports available to investors at the time the shift occurred.Over 20% of Robert Schiller’s “Irrational Exuberance” was devoted to discussing the impact of the news media, and investor’s responses to the publications of the time.In this regard we consider trends in the media over time, alongside investor reactions to media publications in the form of price movements in the real estate market.We assume for purposes of this analysis that investors react to inputs from the media and making buying and selling decisions accordingly as was discussed previously in this chapter.It is up to the reader to evaluate the validity of this proposition, but we believe there is ample evidence suggesting that inputs received from the news media plays as significant role in the psychology of a market’s participants for the reasons discussed above.

1 comment:

Wow, excellent article. Many people don't realize that they are just a victim of media infucence and the these signals can be manipulated by certain people. This bullish trend appears also here in Slovakia, where people are in panic, that prices of the real estates will rise endlessly. They are able to take 40-year mortgage to buy a single flat, because they just believe the price will be appreciated. This reminds me the Tulip market in holand and it seems to me that this just a big investment bubble.

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Carl Rheuban is chief operating officer of KeyFlame Energy Advisers. KeyFlame is a leading advisory firm on torrefaction processing. Mr. Rheuban is a technology and project development consultant on torrefaction process plant planning, development, fabrication and installation. Torrefaction is a process to convert wood and other biomass materials into torrefied pellets that are a clean renewable fuel with low ash and low sulfur that is used to replace coal at coal fired power plants.
Carl Rheuban developed his experience in the real estate industry working as the General Partner and Chief Financial Officer of De Anza Properties, where he procured and developed luxury water oriented manufactured housing retirement projects with over 10,000 homes. Even after De Anza Properties was sold in 1993 to Sam Zelle's REIT, Carl Rheuban individually acquired hundreds of millions of dollars in real estate for his own account and for others he consulted.In addition to renewable energy and real estate,
You can read more of my work at RheubanPost.com - by Carl Rheuban